Repo 105 and Financial Funny Business

There has been a lot of talk about Lehman’s use of Repo 105s in the press recently but not a lot of good explanation of what it actually means. A repo loan is a loan where the borrower “sells” an asset today for cash and promises to buy the asset back at a higher price in the future. It is basically a collateralized loan with an obligation to re-purchase (“repo”) the collateral. There’s nothing bad about this. Its a very common practice in the financial world.

So what’s the deal with Repo 105? Mark Chu-Carroll gives a nice summary at his blog Good Math Bad Math:

A repo105 is a repurchase agreement where you borrow $100, using $105 worth of property as collateral. Then you can, in your financial statements, put that down as a sale with a roughly $5 loss.

Why would Lehman want to record the loss? Well, Chu-Carroll explains, you may want to do that to hide even worse potential losses you might suffer. Imagine you own a bunch of bad CDOs, ones you fear are going to be just worthless trash. What do you do? Chu-Carroll continues:

If you own them, then you need to mention them in your financial statements, and you need to estimate just how much you lost on them. That can make you look really bad…So, here’s what you do. You wait until just before you’re required to issue your financial statement. Then, you set up a repo of the things that you don’t want to show in your books. They’re garbage – so you can’t really sell them. But if you do a repo105, then you can claim to have sold them. And instead of losing 80 or 90 percent of their value, you lost a measly four percent. No biggie there. So you do the repo, and you do it for a term of 7 days.

Now, since you “sold” them, you don’t need to mention them in your financial statements. You don’t need to talk about how much money you’re on the hook for with those. After all, you sold them for close to 96% of their face value! They’re off your picks. Any liability you have from owning them, you’ve just erased. Poof! They’re gone.

The shadiness is evident. Instead of being transparent about their true positions, companies doing repo105 loans hide some of their weaknesses to make themselves look stronger than they really are. Is this permissible under the rules of the game? Or should we have a higher standard?